Appraisal Arbitrage

Gambling on Fair Value

What is appraisal arbitrage?

Appraisal arbitrage is when activist investors acquire many shares in a target (public) company, shortly after a merger is announced, with the specific purpose of asserting and benefiting from appraisal rights.

Under Delaware* legislation, the appraisal remedy exists to protect shareholders who are forced to sell their shares in a merger. Simply put, under the legislation dissenting shareholders to a transaction are entitled to the Fair Value of their shares.

However, a shareholder who acquires their shares after the vote on a merger can still assert appraisal rights.1 Consequently, a prospective activist investor can analyse and invest post transaction and still potentially benefit from an appraisal remedy.

Assessing value in Court

In assessing the value of a public company, stock market prices are often considered a reliable indicator of value, providing the stock is liquid and the markets efficient.

If the transaction occurs between independent parties at arm’s length, then the transaction price may also be considered. That is providing there was a well-constructed sale process and a go-shop provision included after a deal was struck. (A go-shop provision allows a public company being sold to seek out competing offers, for a month or two, even after it has received a firm purchase offer).

If the Delaware Court finds that the market price or transaction price can-not be relied upon then the Court relies on a Discounted Cash Flow model based valuation from the experts.

Appraisal cases in the Delaware Court

According to research on 15 appraisal cases in the Delaware Courts2, 9 transactions were found to be at arms-length, with a well-constructed sales process and a go-shop provision. In those 9 cases the Court awarded no or a very little premium to the transaction price.

In the other six cases the Court found the sales process was inadequate and with no or poor go-shop provisions. In those cases, the Court found the premium awarded ranged between 19.5% and 148.8%!

In other-words, those dissenting shareholders were in some cases entitled to more than twice as much money as the non-dissenting shareholders.

Appraisal remedy in action – Dell

In 2013 Michael Dell took control of the computer firm that he originally created. The shareholders backed his $25bn offer to take Dell private. Certain activist shareholders dissented and an appraisal case was brought3.

Dell argued that the company ran a well-constructed sales process. After signing the merger agreement, the go-shop provision was exercised and advisors were appointed and 60 buyers were contacted and bids were received.

The Court found otherwise, in particular:

Lack of meaningful discussion with alternative buyers prior to signing the merger agreement. That no strategic buyers, eg. competitors, were sought in the process. The board only approached two prospective buyers at the pre-signing stage. In not getting competitive bids prior to the signing, the impetus was lost for negotiating a much better deal later-on.

The incumbent management has the best insight into the company and so without expensive and time consuming due diligence (the go-shop clause was 45 days) it is difficult for a buyer to justify outbidding an insider.

A gap between value and the market price (and the market’s short term focus). Michael Dell, as founder and key shareholder had an insider’s (and long term) view on the future of the company.

The Court dismissed the merger consideration and crafted its own appraisal considering the two expert’s valuations. The Court concluded a Fair Value at a 28% premium over the transaction price. A difference of $6b.

What this means

In simple terms, this means in valuations to remember that:

Market prices might not reflect Fair Value, and

Transaction prices might not reflect Fair Value

When contemplating a related party transaction (and potentially dissenting shareholders) ensure a bone-fide, transparent, carefully constructed bidding sales process is in place (before any agreements are signed with related parties).

Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the largest Bernie Madoff feeder fund. He has also held senior management positions with Deloitte and Crowe Horwath. Simon is a Chartered and a Certified Fraud Examiner.

*Many US Public companies are registered in Delaware for tax reasons. ** Share Tracing. In the Dell matter 31.8 million of shares were statutory disqualified from seeking an appraisal remedy because those shares voted in favour on the merger.4